Tuesday, April 5, 2016

India cuts rate 25 bps, to respond as space opens up

    India's central bank cut its policy repo rate by 25 basis points to 6.50 percent, as expected, and signaled that it was ready to ease its policy stance further by saying it would respond "with further policy action as space opens up."
    The Reserve Bank of India (RBI), which cut its rate by 125 basis points last year and last month said it was waiting on how inflation would evolve, again underscored that it wanted to ensure that the current and past rate cuts were transmitted by banks to their lending rates and the recent introduction of a marginal cost of funds based lending rate (MCLR) should help improve the transmission of its policy and magnify the effects of its latest rate cut.
    "The stance of monetary policy will remain accommodative," said RBI Governor Raghuram Rajan.
    India's consumer price inflation rate eased to 5.18 percent in February from January's 5.69 percent, below market expectations and Rajan's expectation of 6.0 percent for January.
    Going forward, the RBI expects headline inflation to decelerate modestly and trend toward 5 percent by March 2017.
    India's economy is likely to strengthen gradually in the current financial year, Rajan said, assuming a normal monsoon, a likely boost to consumption from higher wages and "continuing monetary policy accommodation.
    Rajan added that the creation of a Monetary Policy Committee at the RBI should strengthen the credibility of its monetary policy and welcomed the government's path toward fiscal consolidation, which should support disinflation, along with its strategy for reinvigorating demand in the rural economy along with a deepening of institutional reforms.
    India's Gross Domestic Product grew by 7.3 percent year-on-year in the final 2015 quarter, down from 7.7 percent in the third quarter.
    India's rupee has been depreciating since the "taper tantrum" of May 2013 and fell by 4.7 percent against the U.S. dollar last year and continued to fall in the first six weeks of this year.
    But since sentiment in financial markets improved in February and investors were encouraged by the government's deficit-reducing budget, the rupee has been firming and was trading at 66.1 to the U.S. dollar today, practically unchanged from the beginning of the year but 4 percent higher than at the end of February.

     The Reserve Bank of India (RBI) issued the following statement on monetary policy and liquidity measures by its governor, Raghuram G. Rajan:

"On the basis of an assessment of the current and evolving macroeconomic situation, it has been decided to:
  •   reduce the policy repo rate under the liquidity adjustment facility (LAF) by 25 basis points from 6.75 per cent to 6.5 per cent;

  •   reduce the minimum daily maintenance of the cash reserve ratio (CRR) from 95 per cent of the requirement to 90 per cent with effect from the fortnight beginning April 16, 2016, while keeping the CRR unchanged at 4.0 per cent of net demand and time liabilities (NDTL);

  •   continue to provide liquidity as required but progressively lower the average ex ante liquidity deficit in the system from one per cent of NDTL to a position closer to neutrality; and

  •   narrow the policy rate corridor from +/-100 basis points (bps) to +/- 50 bps by reducing the MSF rate by 75 basis points and increasing the reverse repo rate by 25 basis points, with a view to ensuring finer alignment of the weighted average call rate (WACR) with the repo rate;

    Consequently, the reverse repo rate under the LAF stands adjusted to 6.0 per cent, and the marginal standing facility (MSF) rate to 7.0 per cent. The Bank Rate which is aligned to the MSF rate also stands adjusted to 7.0 per cent.

2. Since the sixth bi-monthly statement of February 2016, global economic activity has been quiescent. Perceptions of downside risks to recovery in some advanced economies (AEs) at the beginning of 2016 have eased, while major emerging market economies (EMEs) continue to contend with weak growth and still elevated inflation amidst tighter financial conditions. World trade remains subdued due to falling import demand from EMEs and stress in mining and extractive industries. In the US, consumer spending was underpinned by a strengthening labour market, but flagging exports proved to be a drag on growth in Q4 and cloud the near- term outlook. In the Euro area, tailwinds in the form of aggressive monetary policy accommodation and still low energy prices have supported activity in an environment beset with uncertainties from the migrant crisis, intensifying stress in the banking sector, and possible Brexit. While Japan escaped recession in Q4 of 2015, a combination of weak consumer spending, business investment and exports has slowed the economy in Q1 of 2016. In China, sluggish industrial production, contracting exports, capital outflows and substantial excess capacity in factories and the property market remain formidable headwinds, notwithstanding significant monetary and fiscal policy stimulus. EME commodity exporters have benefited recently from the firming up of commodity prices and risk-on investor sentiment has appreciated their currencies. Across EMEs, however, weak domestic fundamentals, lacklustre external demand and country-specific constraints continue to restrain growth.

3. Global financial markets have recouped the losses suffered in the turbulence at the beginning of the year. From mid-February, a firming up of crude prices buoyed market sentiment, allaying fears of global recessionary risks. With China reducing reserve requirements, the ECB expanding accommodation and the Fed providing dovish guidance while staying on hold, equity markets rallied. In bond markets across AEs and EMEs, yields gradually eased, with country-specific variations. The US dollar has retreated from January peak and has eased further in the aftermath of the FOMC’s March meeting. On the other hand, the euro and the yen have appreciated, reacting perversely to exceptional accommodation. Currencies across EMEs have also appreciated as portfolio flows returned cautiously to local debt and equity markets. Gold prices have jumped 16 per cent in Q1 of 2016 on safe haven demand. Commodity prices, including oil, have picked up recently, though they still remain soft. However, the uneasy calm that prevails in financial markets could be dispelled easily by a sudden return of risk-off investor sentiment on incoming data, especially pertaining to China or to US inflation.

4. On the domestic front, gross value added (GVA) in agriculture and allied activities moderated in H2 of 2015-16, pulled down by the contraction in Q3 due to the year-on-year decline in kharif production. Turning to Q4, second advance estimates of the Ministry of Agriculture indicate that despite acutely low reservoir levels and a deficient north-east monsoon, rabi foodgrains production increased over its level a year ago – mainly in wheat and pulses – and compensated partly for the shortfall in kharif output. Unseasonal rains and hail in March are likely to have damaged some winter crops, particularly wheat, although full estimates of the crop loss await advance estimates. On the other hand, fertiliser production has picked up, and horticulture as well as allied activities have remained resilient, suggesting that the implicit estimate of GVA for agricultural and allied activities in Q4 in the CSO’s advance estimates is likely to be achieved, if not revised upwards.

5. Value added in industry accelerated in H2, led by manufacturing which benefited from the sustained softness in input costs. By contrast, industrial production remained flat with manufacturing output shrinking since November. Robust expansion in coal output has buoyed both mining activity and electricity generation and stemmed the weakening of industrial output. However, capital goods production fell into deep contraction since November, even after excluding lumpy and volatile items like rubber insulated cable. Weak demand and competition from imports have muted the capex cycle. Consumer non-durables production has been shrinking, with a pronounced decline in Q4. This reflects the continuing slack in rural demand. On the other hand, consumer durables remained strong, even after abstracting from favourable base effects, which suggests that urban demand is holding up. With improved perceptions on overall economic conditions and income, the Reserve Bank’s Consumer Confidence Survey of March 2016 shows marginal improvement in consumer sentiments. The March manufacturing purchasing managers’ index (PMI) continued in expansionary mode on the back of new orders, including exports. The Reserve Bank’s industrial outlook survey suggests that business expectations for Q1 of 2016-17 continue to be positive.

6. Services sector activity expanded steadily through the year, with trade, hotels, transport, communication and public administration, defence and related services turning out to be the main drivers in H2. The construction sector continues to be overburdened by unsold inventory in the residential space, although commercial real estate is being boosted by demand from information technology (IT) and IT-enabled services. Road construction has accelerated, including in terms of new awards. Cement production appears to have gained traction during H2, while steel consumption has increased at a steady pace. Various lead and coincident indicators such as air passenger traffic, air cargo volumes, foreign tourist arrivals and auto sales increased, while railway freight traffic marginally contracted. The services PMI remained in expansion mode during H2 on new business and expectations. The outlook for services in surveys is upbeat for Q1 of 2016-17.

7. Retail inflation measured by the consumer price index (CPI) dropped sharply in February after rising for six consecutive months. This favourable development was due to a larger than anticipated decline in vegetable prices, helped by prices of pulses starting to come off the surge that began in August, and effective supply management that helped limit cereal price increases. Accordingly, food inflation eased for the first time in the second half of 2015-16. Notably, this occurred on a decline in prices rather than favourable base effects, which were at work in the first half of the year. Inflation in the fuel group moderated across electricity, kerosene, cooking gas and firewood, the latter easing pressures on rural inflation. Three months ahead household inflation expectations declined to a single digit for the second consecutive round of the survey in response to these dynamics.

8. CPI inflation excluding food and fuel edged up in February, mainly under housing, education, personal care and transport and communication, suggesting capacity constraints in the services sector. Excluding petrol and diesel from this category, inflation stayed elevated and persistent at or above 5 per cent, indicating a possible resistance level for further downward movements in the headline. The stubborn underlying inflation momentum is unlikely to be helped by the 7th Pay Commission award and the effects of the one-rank-one-pension (OROP) award, or by the cost-push effect of the increase in the service tax rate. However, rural wage growth as well as the rate of increase in corporate staff costs was moderate. Also, input and output prices polled in purchasing managers’ surveys rose modestly for manufacturing and services.

9. Liquidity conditions, which had tightened since mid-December, were stretched further by the larger-than-usual accumulation of cash balances by the Government, unusually heightened and persistent demand for currency, a pick-up in bank credit and flatter deposit mobilisation at this time relative to past years. The Reserve Bank undertook liquidity operations to quell these pressures and supplemented normal operations with large amounts of liquidity injected through fine-tuning variable rate repo auctions in tenors ranging between overnight and 56 days. The average daily liquidity injection (including variable rate overnight and term repos) increased from
1,345 billion in January to page3image282561,935 billion in March. Besides, durable liquidity was also provided through open market operations (OMOs) of the order of page3image29280514 billion and page3image29784375 billion through buy-back operations in February and March. The Reserve Bank also started conducting reverse repo and MSF operations on holidays in Mumbai to enable the frictionless functioning of the payment and settlement system.

10. Effective April 2, 2016 the statutory liquidity ratio (SLR) of scheduled commercial banks was reduced by 25 basis points from 21.5 per cent to 21.25 per cent of their NDTL. Also, from February 2016, banks were allowed to reckon additional government securities held by them up to 3 per cent of their NDTL within the mandatory SLR requirement as level 1 high quality liquid assets (HQLA) for the purpose of computing their liquidity coverage ratio (LCR), thereby taking the total carve-out from SLR available to banks equivalent to 10 per cent of their NDTL. These measures will create space for banks to increase their lending to productive sectors on competitive terms so as to support investment and growth.

11. FCNR(B) deposits and associated swaps undertaken in September 2013 are expected to mature starting September this year. It is important to note that these swaps are fully covered by the Reserve Bank’s forward purchases. Moreover, the Reserve Bank will monitor developments closely to contain any unanticipated market volatility associated with the repayment.

12. While exports declined in February in US dollar terms for the fifteenth successive month, the rate of contraction narrowed to a single digit for the first time in this period and volume growth turned positive. The decline in non-POL exports was even smaller, with gems and jewellery, drugs and pharmaceuticals, electronics and chemicals driving the upturn. The prolonged contraction in imports also slowed significantly, and non-POL non-gold import growth turned positive for the first time after seven months. This reflected a sizable upsurge in imports of machinery, supported by a pick-up in imports of pearls and precious stones and electronic goods. With gold imports falling in February and March, the continuing softness in crude prices working favourably in terms of conserving the POL import bill and some gains in terms of trade, the trade deficit narrowed to its lowest monthly level since September 2013. In turn, this has likely lowered the current account deficit (CAD) in Q4 below 1.3 per cent of GDP recorded in Q3, despite a moderation in net receipts from services exports and remittances. Net inflows in the form of foreign direct investment (FDI) were robust in Q4 (up to January), more than sufficient to fund the external financing requirement. Foreign portfolio investors (FPIs), who were net sellers in the domestic capital market up to February, became net buyers in March in both equity and debt segments.

Policy Stance and Rationale
13. Inflation has evolved along the projected trajectory and the target set for January 2016 was met with a marginal undershoot. Going forward, CPI inflation is expected to decelerate modestly and remain around 5 per cent during 2016-17 with small inter-quarter variations (Chart 1). There are uncertainties surrounding this inflation path emanating from recent unseasonal rains, the likely spatial and temporal distribution of monsoon, the low reservoir levels by historical averages, and the strength of the recent upturn in commodity prices, especially oil. The persistence of inflation in certain services warrants watching, while the implementation of the 7th Central Pay Commission awards will impart an upside to the baseline through direct and indirect effects. On the other hand, there will be some offsetting downside pressures stemming from tepid demand in the global economy, Government’s effective supply side measures keeping a check on food prices, and the Central Government’s commendable commitment to fiscal consolidation.

14. The uneven recovery in growth in 2015-16 is likely to strengthen gradually into 2016-17, assuming a normal monsoon, the likely boost to consumption demand from the implementation of the 7th Pay Commission recommendations and OROP, and continuing monetary policy accommodation. After two consecutive years of deficient monsoon, a normal monsoon would work as a favourable supply shock, strengthening rural demand and augmenting the supply of farm products that also influence inflation. On the other hand, the fading impact of lower input costs on value addition in manufacturing, persisting corporate sector stress and risk aversion in the banking system, and the weaker global growth and trade outlook could impart a downside to growth outcomes going forward. The GVA growth projection for 2016-17 is accordingly retained at 7.6 per cent, with risks evenly balanced around it (Chart 2).

15. In its bi-monthly monetary policy statement of February 2, 2016, the Reserve Bank indicated that it awaits further data on inflation as well as on structural reforms in the Union Budget that boost growth while controlling spending. Given recent data, forecasts in Chart 1 indicate that inflation will trend towards the 5 per cent target in March 2017 under reasonable assumptions. The changes to the RBI Act to create a Monetary Policy Committee will further strengthen monetary policy credibility. In the Union Budget for 2016-17, the Government has adhered to the path of fiscal consolidation and this will support the disinflation process going forward. The Government has also set out a comprehensive strategy for reinvigorating demand in the rural economy, enhancing the economy’s social and physical infrastructure, and improving the environment for doing business and deepening institutional reform. The implementation of these measures should improve supply conditions and allow efficiency and productivity gains to accrue. Given weak private investment in the face of low capacity utilisation, a reduction in the policy rate by 25 bps will help strengthen activity and aid the Government’s initiatives.

16. Perhaps more important at this juncture is to ensure that current and past policy rate cuts transmit to lending rates. The reduction in small savings rates announced in March 2016, the substantial refinements in the liquidity management framework announced in this policy review and the introduction of the marginal cost of funds based lending rate (MCLR) should improve transmission and magnify the effects of the current policy rate cut. The stance of monetary policy will remain accommodative. The Reserve Bank will continue to watch macroeconomic and financial developments in the months ahead with a view to responding with further policy action as space opens up."



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